Austerity measures have stopped Europe from going further down in the dumps. But now, the focus should be on motivating demand30/04/2013

The problems afflicting the European economy are both unique and baffling. The austerity measures adopted by many Eurozone countries have proved to be an absolute failure. That raises the question if Europe has gone wrong in its economic diagnosis and prescription? After all, if the US took to practising austerity measures to balance its budget successfully during 1990s, why has a similar therapy not been efficacious in the case of Europe? If resorting to austerity measures has benefited small economies like those of Ireland and Portugal, why have these measures come a cropper in the case of the troubled economies of Spain, Italy and France?

The short answer is that the game of fiscal consolidation plays out differently in various contexts and situations and the results are not always uniform and can often be contrary to the expectations. So what once worked for the US has not as efficiently worked in Europe and there could be several reasons for this failure.

Firstly, austerity measures that combine massive spending cuts with tax increases often prove to be a flawed prescription. European governments have planned to cut spending upto 5% of the GDP. While spending cuts by governments have depressed demand, it has also become an impediment in containing fiscal deficit. Moreover, increase in tax rates has affected supply-side economics. Even as taxes are increasing for the ordinary people, order books for both the private and public sectors have been shrinking. This dichotomy has sired new socio-economic problems such as unemployment, budget deficits and recession. Ultimately, cuts in spending alongside massive tax increases are creating imbalances in the economy.

Secondly, Europe has been facing a major problem of liquidity crunch. To deal with the problem, a program called the European Stability Mechanism (ESM) was launched. It has temporarily helped to bring solvency to banks but has otherwise had little success in tiding over Europe’s fiscal challenges.

Thirdly, European governments have failed to grasp that any wealth generation is only helping the rich and not the middle and lower classes. The situation in the United Kingdom exemplifies this problem. An analysis done by the Office of National Statistics, UK, and an article published by the Guardian in April last year, show that the GDP of UK has increased from £621 billion in 1976 to around £1.5 trillion in 2011. However, wages and salaries paid to employees have declined from 65.1% to 54% of the GDP during this period and is expected to decline further below 50%. More interestingly, earnings from £100 of the GDP of an employee at the bottom half of the earnings pecking order has declined from £16 in 1977 to £12 in 2010 while it has increased from £12 to £14 per £100 of the GDP for the top 10% of earners.

Obviously, there are structural problems bedeviling the European economy. Otherwise, how can an economy full of Nobel Prize winning economists continue to suffer the pangs of sovereign debt crises since 2010 and still not be able to get to the bottom of the problem. Of course, the solutions are not easy to find. However, there could be lots of alternatives if the Eurozone countries opt for a less cut-and-dried approach to solving their problems.

Keynesian economics worked during the post World War II era as it focussed on huge infrastructural development according to the contingencies of the times then. But today, the same cannot be replicated as a panacea for the economic ills prevailing in the Eurozone today. Merely controlling demand has backfired badly. Rather, their fiscal policies and reforms should aim to increase the GDP substantially. What the Eurozone countries need to do is to find solutions through the entrepreneurial route, put the mojo back into their production, alongside innovation and manufacturing. That could possibly do the trick and revive their economy.